As mentioned in our first Back to Basics article, relationships can’t be your sole determination for risk and should take a backseat to hard facts. After all, bad things can happen to good people and not making data driven decisions about who to lend to and what to lend on can leave you in a tough position and your principal investment at risk.
In this second installment of our Back to Basics series, we address one of the most important ways to secure a private loan through safe equity buffers. Especially for new borrowers who are unknown entities, high equity buffers (represented as low loan-to-value or LTV ratios) are critical until a borrower can prove themselves. Many seasoned private lenders will tell you experience and relationships can often justify higher LTVs based on their proven track record. However, this can still lead to challenging situations if you aren’t prepared or lack experience.
Covering Your Ass(ets)
My husband often quips “What could possibly go wrong?” when discussing complex loan requests. We often find ourselves ratholed on deals trying to make sense of the gray areas rather than pushing them out due to risk factors. It takes discipline to temper the need to deploy funds with the need to protect our own principal investments as well as those of our capital partners.
In reality many things could go wrong during your loan such as market fluctuations, project mismanagement, budget overruns, etc.; all these scenarios further pecking away at what little protective equity buffer in place. First, you have back interest and default interest well as any late fees you identified in the Promissory Note. But before you can be paid out, there are other parties which could get paid out before you which you’ll need to protect against:
>> Senior lien position loans: If you are a junior lienholder, first lender will need to be paid out before you including any default interest and penalties, which can rack up quickly with hard money lenders
>> Delinquent real estate taxes if your borrower has failed to stay current
>> Mechanic liens from contractors who’ve placed claims against the property for money owed to them based on services provided before the date your loan recorded
>> Attorney fees associated with a default or foreclosure proceeding are almost always paid for upfront by the foreclosing lender
Taking Extra Care
>> New or novice lenders: If you are new(ish) to private lending you may want to be extra cautious while you learn steps to evaluate and underwrite a prospective loan .
>> Low volume lenders: If you originate loans a few times a year, getting reacquainted with market conditions can be challenging so a conservative approach to is prudent.
>> Complex projects or loan scenarios: If you’ve only done vanilla “fix and flip” loans and your client requests a new construction loan or to purchase a commercial building, you will need to learn how to vet the deal since project financials and exit strategies vary greatly by asset class.
>> Lending out of state or new markets: If you are unfamiliar with the market, you will be lending in or you are lending out of state, lower loan to value (LTVs) loans are a good idea until you better understand market dynamics.
Widening the Gap
I often meet aspiring lenders with “smaller” amounts of capital who are eager to get their funds deployed and earning passive income. Many do not yet qualify as accredited investors and are unable to participate in pooled mortgage funds or syndications. These limitations make “do-it-yourself” private lending investments one of the few available options. As a result, lenders with limited capital end up in a few scenarios which pose greater risk of principal loss.
One such scenario is to provide gap fund loans or, in other words, provide the funds needed for down payment assistance and/or rehab costs while another primary lender funds the majority of project costs in first position. In my home market of Seattle, for example, median home prices exceed a half million. While $50,000-$100,000 is still a large chunk of change in my book, it won’t stretch far on a standard fix and flip deal. This leaves private lenders with limited capital to take on riskier gap funding loans, often in 2nd position or unsecured, to fill the gap between total project costs, what’s financed by another primary lender and borrower capital contributions, if any.
Why is this risky? For starters, you’re at nearly 100% LTV right out of the gate. For example, if the borrower obtains an 85% LTV loan from a hard money lender for their project and asks you to gap fund the remaining 15%, there is zero equity buffer to protect you.
Lack of borrower capital contributions means the borrower could walk away with little skin in the game. It also could mean the borrower has little capital to cover unforeseen expenses. And if the first position loan defaults, high default interest rates and possibly steep balloon payment penalties could be imposed leaving you at risk of your principal loan amount being shorted.
When Cash(flow) Isn’t King
Another loan scenario often entertained by lenders with limited capital is to lend out of their home state in smaller markets where property values are less expensive. These markets generally are more inland or rural compared to coastal metropolitan markets that can often be saved through appreciation.
While this may sound attractive as an easy way to get started in private lending, these “cash flow” markets tend to have home values which remain relatively flat by comparison to larger metropolitan markets. If you choose to lend to investors buying in these states, you’ll need to pay particular attention to home prices and market appreciation trends, average days on market, and other demographic-related factors that could adversely affect your principal loan amount. It may sound great to buy a in the Midwest for $60,000 with rental income of $700/month but if your LTVs start out too high and the project goes over budget or the market dips, you may find yourself underwater and unable to offload the loan or property without a significant principal loss.
Additionally, many financial institutions won’t lend below $100,000 so be sure to have your borrower pre-qualify their take-out financing if they plan to BRRRR.
Other Preventative Measures
What are reasonable equity buffers? That all depends on the project and loan type as well as your own risk tolerance. While I personally prefer to remain within a 30% equity buffer or greater (70% LTV), there are other loan terms I rely on to give me further protection in the event of default and every lender needs to figure out the sweet spot which allows them to be comfortable with the loan and sleep well at night.
>> Cross-collateralization: Adding other properties already owned by the borrower can help provide additional equity protection but also an added incentive for the borrower to perform. After all, nobody wants to lose a property, let alone two or three.
>> Rehab or construction holdbacks: If you are funding rehab or construction costs, keeping a portion of those monies back until certain milestones in the project are reached can help ensure the project starts off on the right foot.
>>Formal property valuations: A lot of private lenders like myself do “in-house” valuations rather than paying for a third party to complete an appraisal or a BPO (broker’s opinion of value) but having one of these done for the as-is values as well as the ARV, or after repair value, can be helpful in shoring up your LTVs and ensuring equity buffers are solid.
If no other collateral exists or you can’t hold back funds for key milestone check-ins, and LTVs are still too high for your taste, strongly consider walking away from the deal. With private money investments, the primary goal should always be return of principal rather than return on investment or ROI. Does it really matter what interest rate you are receiving if the principal amount you lend out could be shorted due to low equity buffers?
Hopefully you feel more confident now with the reasons why protective equity buffers are one of the most important ways to protect your private money investment. The goal isn’t to scare you off, but instead give you the full and raw picture of the potential risks you could encounter when you don’t safeguard against the unforeseen.